Lecture 9: Research and development Tom Holden io.tholden.

org

What does R&D do? Does competition encourage or discourage R&D? Business stealing and entry deterrence. Patent races. Policy instruments.
And a diversion into auction theory. R&D in oligopoly.

Two fundamental types of research:

Horizontal innovation.

Product research is focused on inventing new products, perhaps of higher quality, or filling consumer demands that are as yet unsatisfied. Process research is focused on improving the productivity of production processes for existing products (or improving their quality).

The output of R&D is knowledge.

Vertical innovation.

Knowledge is non-rival (it can be used by many firms at the same time). Is is also often non-excludable in the absence of intellectual property protections. Non-rival plus non-excludable = public good, suggesting R&D will be under-supplied.

Suppose for some reason there will only ever be one firm in an industry with demand curve and constant marginal costs of . Profits are and the FOC says: 0 = + . How do optimum profits change as changes?
So even a monopolist would prefer to have lower costs, so will undertake some cost-reducing R&D.
By the envelope theorem, = =

< 0.

Suppose a very large number of firms compete (under any plausible mode of competition). Then as long as all firms have costs drawn from the same distribution, profits will be basically zero. Given R&D is a cost, if firms expect zero profits anyway there is no point them performing R&D. Possibly R&D enables a firm to steal the market, and thus make significant profits, but in a symmetric equilibrium all firms perform the same amount of R&D and so end up with the same cost distribution (and so zero profits).
Idea: if I got lucky with my research, then if there are enough firms, the chances are that someone else did too.

Affordability considerations suggest research should be decreasing in concentration. Are there any other effects? Consider a linear-cost Hotelling model with asymmetric costs, and .
Firm makes profits of

1 + . FOC implies 2 2 1 1 = + + . Likewise = + + . 2 2 2 1 1 2 Thus, = + + and = + + . 3 3 3 3 2 3 + 3 + 2 Hence firm s profit is and s is . 18 18

Now suppose that before production, firms can invest in cost-reducing R&D.

In particular suppose = 1 and = 1 , where is the amount of research done by and is the amount done by . 1 2 Suppose s research costs a total of and s costs 2 1 2 .
2 Then total firm profits are and 2 3+ 2 1 2 respectively. 2 18 3+ 3 Firm s FOC tells us: 0 = , so = . 19 9 3 Likewise = . 3+ 2 18 1 2

Hence, =

19 1 = 3

> 0.

To understand whats driving firms to perform this amount of research, imagine for the moment that cutting price did 1 not expand demand, (so both firms sell to the line) but 2 firms still set the prices from before.
2 Total profits would then be: + and 2 3 3 2 1 1 1 1 2 + respectively.

So in this model, when we turn off the business stealing effect of research, the amount performed is halved.

Firm s FOC implies: 0 = , so =

1 6

1 6

and =

1 . 6

Business stealing is an important incentive to perform research. When there is only one firm, there can be no business stealing. When there are many firms, there is a greater potential to expand market-share by undercutting the others.

Affordability:

Firms in highly competitive industries do not make enough profits to cover the costs of research, even when that research increases their profits.

Business stealing:

By performing research firms in competitive industries can cut their price and expand their market share.

Data suggests both effects are important.

Aghion et al. (2005) show that both highly competitive and highly concentrated industries perform little research.

Following Dasgupta and Stiglitz (1980). Three stage game: entry, R&D, then quantity choice. MC of firm is given by where is the research expenditure of firm in the first stage. Demand curve is = , hence from lecture 1 we know that in the final stage firms will set 1 1 = . =1
1

When the number of firms is large, the effects of s research choice on the price will be small. For simplicity then, we suppose firms treat the price as fixed at .

In the second stage then, firm chooses to maximise , meaning: 0 = 1, so will be identical across firms.
E.g. if =

then 1 =

, 2

so = .

In the first stage we have a free entry condition.

There is no fixed entry cost, but effectively functions as an entry cost. The zero profit condition says: = , i.e. 1 = (from dividing through by ). But = (since all firms choose the same ), thus: 1 =
,

The LHS here is a firms R&D expenditure to revenue ratio. Thus, firms do relatively more R&D in concentrated industries (but beware: the assumption that R&D does not affect the price will be poor in concentrated industries). They also do relatively more when demand is inelastic. These effects are driven by affordability like considerations. Relative research is determined by pricing and free entry, not the R&D FOC.

i.e.

= .

Suppose that patents give innovators full property rights over their process improvements, but nonetheless disclose all the knowledge they contain. Consider an industry with one incumbent firm with marginal cost 1 , and a potential entrant. Either the incumbent firm or the entrant may perform research, to bring 1 down to some fixed lower level 2 . Given an MC of 1 a monopolist sets a price 1 and given an MC of 2 a monopolist sets a price 2 . Distinguish two cases:
Drastic innovation: 2 < 1 so the new technology enables whoever discovers it to become a new monopolist. Non-drastic innovation: 2 > 2 .

Value of the innovation to the innovator depends on who the innovator is.
The incumbent would gain . The new entrant would gain . The social planner would gain + + .

1 2 2

Value of the innovation to the innovator depends on who the innovator is.

The incumbent would gain . The new entrant would gain + . The social planner would gain + + .

Under either drastic or non-drastic innovation, a new entrant values the innovation more highly than the incumbent.
So we should expect firms to leapfrog each other, with incumbents never performing research. Idea: the monopolist is competing with itself, whereas a new entrant is starting from nothing. (Replacement effect) So there is too little research and a role for policy.

Neither the incumbent or the entrant value innovations as much as the social planner would.

Slightly unsatisfactory to have fixed, non-risky 2 though, and to suppose that reading a patent enables you to perform the innovation as well as the innovator.

As before the incumbent starts out with an MC of 1 . An R&D lab is attempting to sell a patent for a new process with an MC of 2 < 1 , by an ascending auction. The entrant would value the patent at 2 , 1 . The incumbent would value the patent at 2 1 , 2 since they know that if they do not buy it, the entrant will. But by the inequality above: 2 1 , 2 2 , 1 , so the incumbent values the patent above the entrant.

Write for monopoly profits with MC . Write , for duopoly profits for a firm with MC of when their rival has MC of .
We do not need to specify the mode of competition. But for any mode, when 2 < 1 , 2 1 , 2 + 2 , 1 as the monopolist always has the option of duplicating the duopoly price(s).

Difference from Arrow (1962) in our entry deterrence model is that here the monopolist realises that if they dont get the innovation, their rival will. (Efficiency effect.) More generally, we might consider a model where both the incumbent and the entrant are working on discovering the productivity improvement, and the more effort they put in today, the higher the chance they will discover it now. Both the replacement effect and the efficiency effect are potentially at work.
But in any given period there is a high chance that neither firm will discover it. (Innovation takes time.)

It may be shown that with drastic innovations, the replacement effect dominates.

Replacement effect: exerting a lot of effort searching for the improvement makes less sense for the incumbent because if they find it the gain for them will be smaller (they are replacing themselves). Efficiency effect: the incumbent knows that if they perform too little research, the entrant will certainly discover the improvement (eventually), and so the fact that monopoly profits are higher than combined duopoly profits means the incumbent will want to perform more.

Suppose risk-neutral firms compete to invent a new product. The inventor of the product will be granted a patent, enabling them to extract some monopoly profits. Firms differ in their costs to produce the product if they invent it, and thus differ in the amount of monopoly profits they would receive.

The firm that performs the most units of research will win the patent race.

Each firms profits if they are a monopolist are drawn uniformly at random from the interval [0, ]. Firms know their own profit draws, but not those of their rivals.

any allocation mechanism/auction in which (i) the bidder with the highest type/signal/valuation always wins, (ii) the bidder with the lowest possible type/valuation/signal expects zero surplus, (iii) all bidders are risk neutral and (iv) all bidders are drawn from a strictly increasing and atomless distribution will lead to the same expected revenue for the seller (and player i of type v can expect the same surplus across auction types). The winning bid should be epsilon above the second highest valuation. (Source: Wikipedia)

Bidders = firms. Valuations = profits if they invent the product. Check each point in turn:

So the RET holds.

(i) holds as the amount of research firms will want to do will be increasing in their profits if they win. (ii) holds because the lowest type of firm makes zero profits if they win. (iii) and (iv) holds by assumption.

Given the RET holds, we can derive firms expected surplus, and hence their bids. Consider this alternative mechanism (the ascending auction AKA the second-price auction):

An auctioneer shouts out prices that grow by 1p at a time, and all bidders hold up their hands while they are prepared to buy at the most recently shouted price. Once only one bidder has their hand up, the item is sold at the most recently shouted price. Equilibrium strategy is clearly the following: keep your hand up while the price is below or equal to your valuation. Thus the good is sold at (1p more than) the second highest valuation. Immediately from the RET we have that the total amount of research performed by all firms is given by the expected second highest profit 1 draw, i.e. . +1 So a bidders expected surplus is the probability that their valuation is the highest, times their valuation minus the expected valuation of the second highest bidder, given their valuation is the highest.

Suppose then that a firm would make profits of if they were a monopolist.
What is the probability that this is the highest draw? It is the probability that the 1 other draws were below , . i.e. Conditional on the highest of the draws being , it may be shown that the other 1 draws are uniform on 0, . Thus the highest of these other 1 (i.e. the
1 1 .

Hence the firms expected surplus is

second highest overall) is expected to be at

1

1 .

So how much research should they do?

1

Expected surplus under the patent race is the probability that you have the highest profit draw times your profit draw, all minus your research expenditure (which you pay even if you do not win the race). By the RET, this expected surplus must equal the expected surplus from the ascending auction, hence 1 1 = . 1 1 1 I.e. = = .
1

I.e. , where is the research expenditure of a firm that drew .

For even moderately large , will be tiny for all but the very highest , so performing near zero amounts of research is optimal.

We have already discussed patents.

Copyright is very similar. In the absence of these the received wisdom is that there would be too little innovation/content creation. Read Boldrin and Levine (2008) for a dissenting view. Once the research has been performed, the social planner would like to set its price to zero (i.e. to distribute it freely). The recent literature has looked more at alternative instruments, such as prizes for innovations (e.g. the X-Prize contest, the DARPA grand challenges, etc.). Direct subsidies for research in firms may also help (if there is too little R&D). Subsidies for blue-skies research (such as my salary) are also possible.
May lead to innovations too risky to be pursued by firms. May be hard to work out before hand what exactly prizes should be offered for.

But patents and copyright lead to ex-post inefficiency.

R&D drives long run growth in the economy.

Policy prescriptions that make sense for individual innovations may nonetheless have terrible consequences in general equilibrium, so great care must be taken with patent policy. In endogenous growth models, it is usually the case that there is too much R&D performed, due to duplication across and within industries.

R&D leads to new products, and better production processes for existing ones. The empirical evidence suggests that industries with a medium degree of concentration will perform the greatest amount of R&D. The theory suggests two contrasting effects of concentration on R&D, that we have called affordability and business stealing. The RET is great Policy is complicated